Dan David, co-founder of the financial information website GeoInvesting, is not a man to beat about the bush when it comes to corporate fraud.
The company - based in the rural American town of Skippack, about 50 kilometres northwest of Philadelphia - has made a name for itself by uncovering a steady stream of lies and deceit practised by US-listed Chinese firms.
Enthusiastic about the long-term growth of these firms, 43-year-old David initially doubted some of the stories that were being circulated. So much so that the company initially started researching US-listed China stocks in August 2010 to refute the evidence of short sellers such as Muddy Waters Research and Alfredlittle.com. But GeoInvesting's research showed that fraud was rampant and being done on a massive scale, David said. The short sellers were correct.
Reluctantly, David's firm also began short selling to unmask the fraudsters and help clear out and clean up the market for smaller investors. Some of the more notable exposures included chicken breeder Yuhe International, Lotus Pharmaceuticals and Puda Coal.
Yuhe claimed to have bought 13 breeder farms, which turned out to be false. Lotus said it spent US$32.7 million on land in Inner Mongolia which GeoInvesting had independently appraised at under US$7 million. In February, the US Securities and Exchange Commission referred to a GeoInvesting report when it alleged that Puda Coal chairman Zhao Ming effectively looted the company and left shareholders with nothing.
But David isn't just angry about the fraud - he also has strong views about the investment banks and bigger research houses involved. The lack of due diligence is no accident because it would compromise the big fees they stand to make. And combined with a perceived lack of co-operation between the Chinese and US governments, the smaller investor is getting less than a fair deal.
How did you become interested in China-based stocks?
In 2006 we noticed that US-listed Chinese stocks were meeting our criteria for great value. As we regrouped after the 2008 global downturn, US-listed China-based stocks became very attractive and we invested over 80 per cent of our portfolio long in mostly Chinese RTOs [reverse takeovers/back-door listings]. We did very well in 2009 with this strategy.
Why did you become particularly attracted to mid and small caps?
We have always been interested in mid and small caps. We believe this is where the best value can be found for investors willing and able to perform quality due diligence.
Are you still fundamentally positive or long on China stocks?
Unfortunately we are not positive or long on China stocks listed in the United States. The RTO market has been shattered by fraud and/or material misrepresentation and the IPO market has a huge issue with the VIE corporate structure ['variable-interest entity', a contract between a Chinese company and the investor that allows the entity to be listed in the US]. With no criminal accountability for fraud perpetrated by China-based companies and the moral hazard inherent in the VIE structure, we do not feel safe investing long in US-listed China stocks, especially when it is not against Chinese law to steal from US investors.
We have always maintained that the fraud represented in the China RTO was committed by both Chinese companies and their US representatives. It is our belief that in many cases CEOs of Chinese companies have been taught to steal by their US representatives - namely their investment bankers, lawyers, and middlemen. I call them fee collectors since they risk little and collect huge fees from Chinese companies and US investors. When we call for accountability, we call for it on both sides of the ocean.
Some of your competitors such as Muddy Waters and Alfredlittle.com have been accused of simply profiting from short selling. How does your approach differ?
The facts show that they were right and it's not just our own research. I'm not speaking about any one company they have reported on, since their work is their work and not GeoInvesting's. I think in general the market has spoken, and if they [Muddy, Alfred] were wrong the RTO stocks would not be where they are today. However, two men or two research companies cannot account for the collapse of dozens of companies. Ultimately this is decided by the market, and the market over time does get it right. Some people say that my company, along with a few others, caused the RTO collapse, but I have to believe that any rational investor knows this cannot be true. What caused this collapse is nothing more than greed and dishonesty from fee collectors, greed and ignorance on the part of Chinese CEOs who trusted them, and most importantly a complete lack of co-operation on the part of the US and Chinese governments.
If Muddy Waters and Alfred Little made a great deal of money on their research, and if it was true and accurate, then they deserve to make whatever they risked. Fee collectors who risked very little made a great deal more money for being inaccurate. I have read many investment bank analyst reports but, by and large, these 'short' reports are much more accurate and contain better research than any investment bank analyst report.
Our approach is considerably different. We put out content every day with much of it being positive research. We focus on all small and micro caps whether they are US companies or US-listed China-based companies. The last three negative reports we published were on US-based companies who we believe are 'pump and dump' schemes [issuing misleading statements in order to sell cheaply purchased stocks at inflated prices] and have nothing to do with China.
Shorting stocks is not and has never been a comfortable strategy for us. We believe shorting stocks is actually good for the market and a solid self-correcting mechanism, but our history has taught us that value investing is much better in the long term. Having said that, if we know that a company has committed fraud and our findings are based on public information we can, and probably will, short its stock.
How do Chinese stocks that list in Hong Kong differ in corporate governance from those in the US, which are mainly through back-door listings?
I do see differences in companies that list in Hong Kong in terms of corporate governance. Hong Kong companies in general are more sophisticated than the typical US-based China RTOs and are on a par with the large cap China initial public offerings listed in America. There is still fraud in Hong Kong but a lower percentage. However, as with US companies there comes more sophistication and the potential for bigger and more audacious fraud, lest we forget Enron and WorldCom. While there are fewer frauds in Hong Kong, the fraud that does exist can be measured in massive dollar losses. I understand that Hong Kong is similar to the US RTO space due to the difficulty of enforcing good governance and due diligence in China given the two systems and one state regime.
What lessons do you think can be learned by investors in Hong Kong from the experiences of investors in the US who put their money into US-listed Chinese companies?
The most important lesson here is that when there is zero accountability, and a lack of government co-operation regarding fraud, then greed and dishonesty will win out, which is the reason we all have laws in the first place. In this kind of environment the outcome will always be the same. This is not the fault of the Chinese people or the American people. On the whole, the average Chinese citizen and American citizen do not see themselves as enemies, but the fact remains that the government of China and the government of the United States are not the friends they claim to be and that's the important distinction. At best we can only say that our governments have important economic interests but agree on little else in the world of politics. This is not a good foundation for a friendship. Honesty, trust, and accountability should be part of the foundation and this will make for a better investing relationship.
GeoInvesting has made its reputation by being an advocate for the small investor. Why do you and your company feel strongly about this?
Because that's who we are and always will be. We were financially comfortable before GeoInvesting, but this was not always the case. My business partner and I did not come from poor families, but we did not come from rich families either. One of the things we have learned in life is that if you do not come from money, then people with money do not easily accept you and tend to treat you as a lesser. We believe this was one of the reasons why fee collectors lied to us so many times. As this did not sit well with us, our current model for GeoInvesting was born.
GeoInvesting provides affordable research that levels the playing field with investment banks and big investors. These institutions will continue to try to minimise what we do by saying we are a small firm relative to them and we are not in New York, so this must mean our research cannot be taken as seriously. If they are so big and wealthy with more resources, how come we have been proven right and they have been proven wrong? We are doing very serious research and we cannot be paid to recommend a company we do not believe in. Who can trust investment bankers when their research reports recommend companies as a 'buy' at a 50 to 1 ratio [of buy to sell calls]? It's just ridiculous.
How is your research done? And how were you able to make such a big impact with your China research from 2010 with only three Putonghua-speaking researchers and one lawyer based in China?
Our research is labour intensive and consists of a thorough review of filings in all applicable countries. We combine this with on-the-ground due diligence of facilities, suppliers, present and past business relationships and transactions, as well as speaking with the community at large.
Your computation of our staff is inaccurate. Unfortunately I am not comfortable discussing any Chinese nationals I may work with since the threats against these individuals by government officials is very real and quite dangerous.
I believe we have made an impact by telling the truth and being as thorough as possible.
Why is there such a lack of due diligence by bigger research firms?
There is a lack of due diligence by bigger research firms and investment banks because they collect fees on transactions. If they find or acknowledge fraud, then there can be no transaction and no money to be made, so at best they remain 'unaware' of certain circumstances; at worst, accomplices in fraud.
So your ethical position is related to the way you make money, from investment, not fees?
We do make money. We probably have not made the kind of money attributable to other individuals you have mentioned, but we are comfortable and building a different kind of business model from them.